Two-sided competition of proprietary vs. open source technology platforms and the implications for the software industry

Technology platforms, such as Microsoft Windows, are the hubs of technology industries. The strategic behavior of a firm controlling a platform affects crucially industry evolution. We develop a framework to characterize the optimal two-sided pricing strategy of a platform firm, that is, the pricing strategy towards the direct users of the platform as well as towards firms offering components that are complementary to the platform. We compare industry structures based on a proprietary platform (such as Windows) with those based on an open-source platform (such as, Linux) and analyze the structure of competition and industry implications in terms of pricing, sales, profitability, and social welfare. We find that, when the platform is proprietary, the equilibrium prices for the platform, the application(s), and the platform access fee for applications can sometimes be below marginal cost, and we characterize demand conditions that lead to this. We find that the social welfare in the software industry may be higher when the platform is open source rather than proprietary and the cost of adopting the open source platform is small. The proprietary applications sector of an open source industry is more profitable than the total profits of a proprietary platform industry when the demand of the proprietary platform is not much stronger than the demand for the application(s) and the own-price effect of the platform is strong (demand for the platform is relatively elastic) while the own-price effect of the application is weak (demand for the application is relatively inelastic). When a system based on an open source platform with an independent proprietary application competes with a proprietary platform with an independent application, the open source system is typically dominant in terms of market share.